Commodity Prices, Monetary Policy and the Taylor Rule

One way to analyze the impact of commodity price shocks on monetary policy is to think about short-term interest rates set by Fed according to the Taylor rule. Taylor (1993) suggested a policy reaction function for moderating short-term interest rates to achieve the two-fold goals of stabilizing economic growth in the short-term and inflation in the long-term. One important question is why monetary policy makers focus on core inflation instead of headline inflation. Therefore, the main goal of this research article is to study the pattern of monetary policy responses to commodity price shocks derived from an impulse response function (IRF). To do this, we first estimate two individual Taylor rules based on core and headline consumer price index (CPI) inflation by using real-time data of the US economy for the Greenspan years from 1987 to 2006 and predict the residuals. Then, we estimate two regressions for core and headline CPI inflation as our two individual dependent variables against some independent variables including commodity price shocks, and the Taylor rule residuals. At the end, we predict the monetary policy responses to commodity price shocks by using IRF analysis in multivariate systems of a vector autoregression (VAR) model.